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IFRS 16
In January 2016, the International Accounting Standards Board (IASB) issued IFRS 16 ‘Leasing’, which represents
the first major overhaul in lease accounting for over 30 years. The Standard brings fundamental changes to lease
accounting that replace previous accounting that is considered no longer fit for purpose. These changes become
effective from 1 January 2019.
This article considers the topical area of ‘Understanding the discount rate’ [ 78 kb ]. Under IFRS 16 ‘Leases’,
discount rates are required to determine the present value of the lease payments used to measure a lessee’s lease
liability. Discount rates are also used to determine lease classification for a lessor and to measure a lessor’s net
investment in a lease.
The incremental borrowing rate is determined on the commencement date of the lease. As a result, it will
incorporate the impact of significant economic events and other changes in circumstances arising between lease
inception and commencement.
A lessee will need to determine a discount rate for virtually every lease to which it applies the lessee accounting
model in IFRS 16. However, a discount rate may not need to be determined for a lease if:
a lessee applies the recognition exemption for either a shortterm or a low-value asset lease
all lease payments are made on (or prior to) the commencement date of the lease, or
all lease payments are variable and not dependent on an index or rate (eg, all lease payments vary based on
sales or usage).
The interest rate implicit in the lease may be similar to the lessee’s incremental borrowing rate in many cases. Both
rates consider the credit risk of the lessee, the term of the lease, the security and the economic environment in
which the transaction occurs.
For some leases, including most property leases, a lack of detailed information about the fair value of the
underlying asset, the expected residual value of the asset at the end of the lease term and any initial direct costs of
the lessor will make it difficult or impossible for the lessee to readily determine the interest rate implicit in the
lease.
In other cases, the lessee may be able to obtain the relevant information from the lessor during the lease
negotiation process. The initial fair value of the underlying asset and residual value of the underlying asset may
also be determinable from a reliable external source. The lessee may be able to reasonably determine that the
lessor’s initial direct costs would not be significant to the overall arrangement. In leasing transactions between
related parties, it is likely that most or all of the relevant information can be obtained by the lessee.
While it is relatively common for some traditional equipment finance leases to make explicit reference to an
interest rate in the lease documentation, caution is warranted. This rate will not represent the interest rate implicit
in the lease if it doesn’t include an estimate of residual value for the underlying asset or take the lessor’s initial
direct costs into account.
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The impact of variable lease payments on the interest rate implicit in the lease
Variable lease payments can impact the calculation of the interest rate implicit in the lease. Only variable payments
based on an index or rate should be included in the calculation of the interest rate implicit in the lease (ie. variable
payments that are included in the definition of lease payments). True variable payments, such as those based on
sales or usage, must be excluded. Unfortunately, this can result in rates that are potentially misleading if the lease
agreement is structured in a way that most payments are variable. If the calculated interest rate implicit in the lease
is negative or otherwise doesn’t make sense, in our view the incremental borrowing rate should be used.
IFRS 16
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IFRS 16
Lease payments
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IFRS 16
Interim periods
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With significant judgement required to assess many of the factors noted above, we expect this to be a challenging
area in practice.
It is important to note that the lessee needs to determine the incremental borrowing rate for the right-of-use asset,
not the underlying physical asset.
About its
In most cases, the lessee will need to determine Cookies On borrowing
incremental This Siterate separately for each lease.
Exceptions are where:
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IFRS 16 allows this practical expedient if the effect is reasonably expected to be materially
the same as a lease-by-lease approach, or
on transition, using the modified retrospective approach, a lessee applies a single discount rate to a portfolio
Options
of leases with reasonably similar characteristics (such as leases with a similarAccept Decline
remaining lease term for a
similar class of underlying asset in a similar economic environment).
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It would not be appropriate for a lessee to use its weighted average cost of capital (WACC), which includes equity
as well as borrowings. An entity’s weighted average cost of capital is not specific to the term, security and amount
of the lease.
It would also not be appropriate for a lessee to use its parent’s incremental borrowing rate instead of calculating
and determining its own rate.
If a lessee has direct borrowings, the effective interest rate on those borrowings may serve as a helpful starting
point for determining the incremental borrowing rate. However, it is important to appreciate this is a starting point
and adjustments are likely to be necessary. The interest rate on the direct borrowings may have been determined at
a date when market conditions and the credit risk of the lessee were different than they are on the commencement
date of the lease, or the borrowing may have been based on a different term or included different security.
Substantial adjustment may be required (in either direction) to the interest rate on direct borrowings to determine
an appropriate incremental borrowing rate and significant judgement will be involved in making these adjustments.
The interest rate implicit in a lease often incorporates an ‘asset risk premium’ reflecting the lessor’s exposure to the
residual value of the asset at the end of the lease term. As these premiums reflect the risks and circumstances of the
lessor, they should be ignored when estimating the lessee’s incremental borrowing rate.
There is an additional complexity involving the way in which a loan’s principal will be repaid. For example, a
lender charging 8% for a fully amortising loan (ie, blended payments of principal and interest over the loan term)
may charge a different rate for a ‘bullet-style’ loan where the principal is repaid all at once at the end of the loan’s
term. Unfortunately, the Standard has no guidance on whether the lessee is required to base its analysis on rates
applicable to fully amortising loans, or whether rates for bullet-style loans might also provide a meaningful starting
point in assessing incremental borrowing rate. While most leases are likely to involve payment streams similar to
an amortising loan, lessees will need to exercise careful judgement and consider all facts and circumstances
relevant to their situation.
Example
Blended rates
An entity purchases a building. Assume that a loan-to-value (LTV) ratio of 80% applies, ie, the lender is only
willing to provide funding for 80% of the appraised value of the building in a secured borrowing. If the entity
chooses to finance 100% of the purchase it will need to finance the remaining 20% at a higher rate using an
unsecured borrowing.
Now assume that instead of purchasing the building, the entity decides to lease it for a period of 10 years and that a
similar LTV ratio applies (ie, the lender is only willing to provide funding for 80% of the estimated value of the
right-of-use asset). How should the lessee estimate its incremental borrowing rate?
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A lessee will need to revise the discount rate when there is a reassessment of the lease liability or a lease
modification.
The revised discount rate is the interest rate implicit in the lease for the remainder of the lease term, unless it
cannot be readily determined, in which case the lessee’s incremental borrowing rate at the date of reassessment or
effective date of lease
modification is used.
The lessee will remeasure the lease liability by discounting the revised lease payments using a revised discount
rate, if either:
Transition
For leases previously classified as operating leases under IAS 17 where a lessee elects to apply IFRS 16 for the
first time using the modified retrospective approach:
the lessee recognises a lease liability at the date of initial application by discounting the remaining lease
payments using its incremental borrowing rate at the date of initial application, and
where the lessee elects to measure a right-of-use asset at its carrying amount as if IFRS 16 had been applied
since the lease commencement date, the measurement is adjusted by discounting the lease payments using
the lessee’s incremental borrowing rate at the date of initial application.
We expect that most lessees will use an incremental borrowing rate at transition that reflects a lease term based on
the number of months remaining from the date of initial application. This is especially where an entity applies a
single discount rate to a portfolio of former operating leases with reasonably similar characteristics. However, as
the Standard is silent on this issue, some entities may choose to determine the incremental borrowing rate by
reference to the original lease term measured from the lease commencement date.
Contact us
We hope you find the information in this article helpful in giving you some detail into aspects of IFRS 16. If you
would like to discuss any of the points raised, please speak to your usual Grant Thornton contact or your local
member firm.
IFRS
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